a) Explain the potential causes of a Balance of Payments deficit on current

account. [10]

Mark scheme
Students are expected to explain at least 3 factors that lead to a current account
deficit.

L3 Good explanation of the potential causes 8-10

2 causes fully elaborated, max 8
L2 An explanation (of the 3 causes) which is somewhat 4-7
elaborated
1 cause fully elaborated (showing clear understanding of the
concept of C/A deficit), max 5
L1 For an answer which contains definitions and listing of causes 1-3

Suggested answer

Introduction

 Define Balance of Payments – a statement of all transactions between

one country and the rest of the world.
 Define Current Account -- Transactions include merchandise trade,
exchange of services [current account] and transfers of capital in both
directions.
 Interpret term “current account deficit” – when there is a net outflow of
funds from the country through current account, mainly occurs when X < M

Body

Explain (any 3) potential causes of current account deficit, i.e. export revenue <
import expenditure.

Choose from a spread of price-related and non-price factors causing CA deficit

(at least one from each category)

Price/ cost-related causes of CA Non-price factors

deficit
1. High domestic inflation
2. Overvalued Domestic Currency
Change in Prices of a Dominant
Export (or Import) Good
3. Loss of Export Competitiveness
and Emergence of Low Cost
Competitors
1. Ambitious Development
Programme
2. Low level of exports due to real
factors
3. Country experiencing strong
economic growth / trading partners
facing a slow down in economic
growth

TPJC/Econs/H2 Semestral Assessment/2008 1

1. Loss of export competitiveness and emergence of low cost competitors

 America’s current account deficit may be due to the emergence of China with
its low labour cost and relatively high productivity especially in the low end
manufacturing sector.
 Result in a loss of export competitiveness of America’s products as the
Chinese products are more preferred due to its low cost.
 Fall in the demand for its exports, assuming a high degree of substitutability
between exports of China and US, export earnings will decrease.
 Imports will increase as residents switch their expenditure to the relatively
cheaper imported goods and assuming price elasticity of demand for imports
is greater than 1, the qty demanded for imports will increase by more than
proportionate to the price reduction resulting in an increase in import
expenditure.

2. Trading partners under-value their currencies

US has accused its trading partners particularly many Asian countries such
as China and Japan of keeping their currencies undervalued.

e.g. under-valued yuan

 US citizens find Chinese goods ________ while Chinese find US goods
______
 for US, TRX ___ while TEM ____
• Assuming the ML condition is satisfied (____ + _____ > __)
• Need to assume elastic dd so that a change in px will bring about …

3. Country experiencing strong economic growth (due perhaps to

government’s MP and FP to stimulate economy)

 Monetary Policy: the interest rate cut means that the cost of borrowing is now
lower relative to the expected rate of return. This will encourage borrowing
and consumption of imports will increase.
 Fiscal Policy: tax cut increases the disposal income of the consumers which
may further increase the consumption of imports.
 Expansionary MP and FP will cause the total expenditure on imports to
increase, leading to a trade deficit assuming the export earnings remain
constant.

4. Ambitious Development Programme

 More applicable for developing countries embarking on industrialization

programme
 Large-scale imports of machinery, plant and equipment, raw materials and
technical know-how, resulting in balance of payments deficit.

TPJC/Econs/H2 Semestral Assessment/2008 2

Conclusion

To sum up, the potential causes of a current account deficit are high domestic
inflation, overvalued domestic currency and a change in prices of a dominant
export (or import) price. A current account deficit could lead to a balance of
payments deficit, ceteris paribus.

Also, causes of C/A deficit vary between developing and developed countries:
developing countries due to ambitious development programme while developed
countries due to emergence of low cost competitors or manipulation of ER by
trading partners.

For reading

US Trade deficit
The U.S. current-account deficits of the past two decades were brought on
primarily by a long downward trend in domestic saving as a percentage of GDP
that began in the mid-1950s and accelerated in the early 1980s.

The decline led to a shortage of funds for domestic investment, which in turn
caused real (inflation-adjusted) interest rates to rise higher than they would
otherwise have been. The higher interest rates attracted inflows of financial
capital from abroad. The need to convert those inflows from foreign currencies
into dollars increased the demand for dollars in foreign exchange markets and
thereby put upward pressure on the value of the dollar relative to other
currencies.

As saving declined as a percentage of GDP, consumption consequently

increased. The rise in consumption was larger than the decline in gross domestic
investment that was induced by the higher interest rates. As a result, total
domestic demand for goods and services--consumption plus investment--
increased, putting upward pressure on the prices of U.S. output.

The upward pressure on the dollar and the prices of U.S. output made U.S.
imports less expensive for domestic purchasers and U.S. exports more
expensive for foreigners. As a result, imports rose and exports fell relative to
what they would otherwise have been, causing a chronic current-account deficit
that equaled the net inflow of foreign investment. The larger supply of goods and
services in the U.S. market partially alleviated the upward pressure on prices.
Nevertheless, U.S. imports remained less expensive for domestic purchasers
and U.S. exports remained more expensive for foreigners than before the drop in
saving, and the deficit consequently continued.

Extracted from Congressional Budget Office website

TPJC/Econs/H2 Semestral Assessment/2008 3

b. Evaluate the relative effectiveness of devaluation and fiscal policy in
correcting a current account deficit. [15]

Mark scheme
Students are expected to explain and evaluate the 2 measures and conclude
which is more effective in correcting a current account deficit (see if there is any
conflict with other macroeconomic goals)

Note: Effectiveness should only be measured by how much it is able to achieve

its intended goal – to correct CA deficit.

L3 Good explanation of both measures. 9-11

L2 Answer contains some elaboration but explanation of measures 5-8
are not fully developed
L1 Listing of various measures. Undeveloped explanation of 1 1-4
measure
E2 Detailed evaluation of the measures 3-4
Weigh the measures and come to the conclusion of which
measure is more effective. Recognize that measures taken
depend on the severity and causes of the deficit. To reduce
deficit, all measures must run concurrently.
E1 Some attempt of evaluation for each of the measures 1-2

TPJC/Econs/H2 Semestral Assessment/2008 4

Suggested answer

Introduction
• List some problems arising from C/A deficit  hence the need for govt
intervention
• To correct C/A deficit, the measures must aim to increase X revenue
and/or decrease M spending

Body
Explain and evaluate the effectiveness of each measure

1. Fiscal Policy

CA deficit may be seen as the result of excessive spending

 part of this spending spills over on M
 the excessive spending fuels inflation and ____ export
competitiveness

It may thus be necessary to stimulate / curb* spending to correct the CA

deficit
 use of expenditure reducing policies

This calls for the use of expansionary / contractionary* FP.

This works in 2 ways:

Contractionary FP, through an increase in direct tax and a reduction in G

 decrease in AD (explain)
 through the multiplier effect, NY declines
 falling demand for all g&s including imports
 TEM ______, CA ______

At the same time, the decrease in AD

 reduce inflation rate in the country
 improve export competitiveness
 assuming dd for X to be elastic, a reduction in X prices will
bring about a more than proportionate increase in quantity demanded
 TRX ______, CA ______

Evaluation of fiscal policy (clever comments)

a. Marginal propensity to import

Where an increase in income tax is used to curb spending:

TPJC/Econs/H2 Semestral Assessment/2008 5

 The reduction in Yd may not have much impact of import demand if the
marginal propensity to import (defined as the fraction of the change in Y
that is diverted to imports) is small.

b. Possible reduction in export potential in the LR

Rise in higher rates of income or corporate taxes may reduce people’s

desire to work or invest respectively since more of their incomes or profits
would be taxed away. People would prefer leisure to work, while firms may
put off additional investments. Reduce AS  slows down LR growth &
reduce SOL link back to effectiveness by noting that the disincentive
effects of the tax increase may reduce the country’s export potential in the
LR

c. Inflexible nature of G

Cuts in govt spending on social programmes e.g. assistance to low

income households might be strongly resisted.

Another possibility

Using Fiscal Policy as a ss-side policy

 A rise in government expenditure (G) on R&D and buying advanced

technological capital equipment could increase the efficiency/ productivity hence
improving our export competitiveness in the long run  increase export revenue
(assuming dd for X to be elastic, a cut in price brings about a more than
proportionate increase in quantity demanded)
 R&D spending geared towards development of new / better products will also
increase dd for country’s exports

Evaluation
 In the SR, a rise in G would cause AD to rise and via the multiplier, NY would
rise. With higher incomes, dd for M will rise. The greater the MPM, the larger the
rise in import expenditure. Ceteris paribus, current account deficit deteriorates.
Other limitations include:
 Long gestation period – it may take many years for the R&D to yield results
Success of the policy depends on the country’s capacity to engage in R&D (e.g.
Do they have the pool of scientists? Do they have the know-how)

2. Devaluation

CA deficit may arise from the preference for foreign-produced goods.

 This calls for expenditure-switching policies to get consumers to
switch from buying imports to buy locally-produced goods.

TPJC/Econs/H2 Semestral Assessment/2008 6

  Examples of expenditure-switching policies include devaluation /
depreciation and import restriction in the form of tariffs and quotas.

Using devaluation as an illustration:

Devaluation of the US$
 ___ PX and ____ PM
 encourage ____, discourage ______
 TRX ___, TEM ____, CA deficit ____

Evaluation of devaluation [clever comments]

a. Elasticity consideration (very important, must learn)

(i) elasticity of dd
 For a depreciation to correct the CA deficit, the ML condition
(____ + _____ > __) must be satisfied. Demand must be elastic
for a Δ in px to produce a ____________________ Δ in QD.
 But dd is elastic only in the _____ run. (Reason: tastes and
preferences do not change immediately and it takes time to
source of substitutes)
 In the SR, the ML condition may not be satisfied. So instead
of improving the CA balance, the depreciation may worsen it in
the SR!

(ii) elasticity of ss
 If local firms are unable to expand output sufficiently to meet
rising dd (i.e. AS inelastic)
 limits the ability to increase X while domestic crs continue to
rely on M
 depreciation unable to correct CA deficit

b. Imported inflation

For industries that rely on imported inputs, a depreciation of the US$ ___
their COP
 the imported inflation cancels out any price advantage for the
exporters from the depreciation

c. Competitive devaluation

If major partners also devalue their currency, i.e. devaluation by one

country triggers a bout of competitive devaluation, the advantages which
the devaluation country hopes to achieve will be nullified. In 1967 when
Britain devalued its sterling, most Commonwealth countries followed suit
and UK’s trade position with them did not improve.

TPJC/Econs/H2 Semestral Assessment/2008 7

d. Loss of confidence

Investors may see the country as one that employs devaluation as a

quick-fix for its BOP problems
 believe that it will resort to devaluation should similar problems
occur in the future
 unwilling to hold assets in the country for fear of exchange losses
 effect on KA balance? Effect on AS & LR EG?
 possibility of trade-off in the various economic goals

Comparison of the effectiveness of the 2 policies in correcting CA deficit

Contractionary FP
Contractionary FP effective as
• decrease in Y (reduce M dd)
• reduction inflation (improve X
competitiveness)
reinforce each other to correct CA
deficit
Useful if the root cause of the CA
deficit is due to excessive spending.
If the root cause of the CA deficit is the
loss of competitiveness with
emergence of low-cost countries, FP
as a ss-side policy, can help.
E.g. govt spending on R&D or training
of workers  higher levels of
productivity  reduce unit cost of
production  improves X
competitiveness.
[Note: recognize that this involves long
gestation period & that devaluation
may be a temporary measure to ‘buy
time’ for the ss-side policy to make its
effects felt.
Devaluation
The policy may be less effective since
the increase in import prices may raise
COP and cancel out any advantage of
devaluation on X prices.
• This is particularly true of a
country whose exports have high
import content (limited natural
resources).
• Less problematic for countries
that have a large service sector as
this sector uses less imported
inputs.
Useful if the CA deficit is due to
currency misalignment (e.g. over-
valued currency)
Not be useful if the root cause of the
CA deficit is the loss of competitiveness
with emergence of low-cost countries
 requires ss-side policies to improve
productivity and restructuring to move
the resources into new areas of
comparative advantage to avoid direct
competition
Devaluation only delays the
restructuring process
Not be useful if the root cause of the
CA deficit is due to excessive
spending. E.g. devaluation of the US
dollar against the Chinese yuan only
encourages its consumers to turn to
imports from third countries.

TPJC/Econs/H2 Semestral Assessment/2008 8

Conclusion

For both measures, there are conflicts with other macroeconomic goals.
Effectiveness of the measures taken will depend on the severity and the
underlying cause(s) of the deficit as well as the current situation of the economy.
In most cases, all the measures must run concurrently for the deficit to be solved
effectively.

TPJC/Econs/H2 Semestral Assessment/2008 9

 Tampines Junior College
2008 JC2 Semestral Assessment
Economics (H2)

Markers’ Report for Essay

(a) Explain the potential causes of a Balance of Payments deficit on

the current account. [10]

(b) Evaluate the relative effectiveness of devaluation and fiscal policy

in correcting a current account deficit. [15]

Part (a)
Strengths:
1. Most students understand that the question is asking for the causes of
current account deficit.
2. Many students are able to fully elaborate at least 1 cause.

Weaknesses:
1. Poor definitions in the introduction, with students using their own terminology for
eg current account deficit is defined as the amount or numbers of exports minus
the amount or numbers of imports.
2. While many students could give at least 3 causes; the explanation could be more
detailed.
3. Many forgot to state the assumptions; Marshall-Lerner condition, high degree of
substitutability between local and foreign goods and ceteris paribus.
4. Quite a handful of students applied the Marshall-Lerner condition in their
explanation of how high domestic inflation causes a current account deficit.
5. Many students tend to consider the substitutability between exports and imports
rather than locally produced goods (for local consumption) and imports.

Part (b)
Strengths:
1. Many students are able to explain how devaluation can correct a current
account deficit.

Weaknesses:
1. Many students defined devaluation as depreciation of the currency and
used the term depreciation rather than devaluation throughout the essay.
2. Quite a handful of students did not explain correctly how fiscal policy can
help to correct a current account deficit.
3. Quite a number of students used expansionary fiscal policy (not as a
supply-side policy), explaining that an increase in AD would stimulate production
and hence there would be more exports produced.

TPJC/Econs/H2 Semestral Assessment/2008 10

4. Many students did not elaborate on the limitations of the policy and link to
how that may undermine the effectiveness of the policy in correcting a current
account deficit.
5. Limitations mentioned were those that were not so significant, such as
how devaluation causes loss of confidence in currency and the presence of time
lags, instead of more significant limitations such as the explanation of the J curve
effect and the negation of advantage from cheaper exports due to higher prices
of imported raw materials. Also, limitation is the in the context of correcting the
current account deficit.
6. A large majority did not weigh the measures and conclude on which is
relatively more effective in correcting a current account deficit.
7. The lack of proper time management was evident in many uncompleted
scripts.

TPJC/Econs/H2 Semestral Assessment/2008 11